Capital Intelligence, the international credit rating agency, today announced that it has revised the outlook on Iran’s ‘BB+’ long-term local currency rating to ‘Negative’ from ‘Stable’. At the same time the agency has affirmed Iran’s long-term foreign currency rating of ‘BB-’ with a ‘Stable’ outlook. The change in the outlook on the local currency rating reflects the slow pace of fiscal reform, limited progress towards developing an effective market-based monetary policy, and increased political and policy risks following contested presidential elections last year. These factors suggest that the default risk on Iran’s local and foreign currency debt may become more closely connected over the medium term.

Iran’s ratings continue to be supported by the considerable hard currency it earns as the second largest oil producer within OPEC as well as by comparatively low levels of government debt in relation to fiscal revenues and GDP. Helped by reasonably high oil prices over most of the past five years, Iran has accumulated substantial foreign currency assets, which are projected at USD73 billion (21% of GDP) in the current fiscal year. Official reserves dwarf annual payments on the country’s declining external debt stock and consequently provide a buffer against external economic shocks.

The central government budget has been in surplus or close to balance for most of the past decade and the fiscal position is expected to remain manageable over the next three years provided oil prices remain above USD65 a barrel. Government debt is low at about 14% of GDP or 65% of budget revenue in 2009/10 and is approximately matched in size by government financial assets.

Iran’s ratings are nevertheless constrained by limited fiscal flexibility and financial disclosure, various structural and institutional weaknesses, and a comparatively high level of political risk. The government’s revenue base is narrow and volatile as oil accounts for about 70% of total income. The expansionary fiscal policy pursued in recent years has increased the rigidity of public expenditure and made the budget more sensitive to downturns in oil prices – a vulnerability that is compounded by the lack of sustainable financing options available to the government. In addition, government contingent liabilities from state-owned banks and enterprises are potentially large, although they will decrease if appropriate reforms are carried out over the medium term.

Capital Intelligence remains concerned about the willingness and ability of the government to deliver appropriate economic reforms, particularly given the more fractious domestic political environment following the disputed presidential elections in June 2009 and broader worries within the political eliteabout the social cost and public reaction to deeper structural reforms.

Iran is also exposed to a comparatively high level of external political risk. International sanctions in response to the perceived threat of Iran’s nuclear programme have reduced the likelihood of the country receiving the foreign investment and technology transfer it needs to raise the economy’s potential growth rate over the medium term and forced the authorities to draw on fiscal reserves to finance imports and industrial projects. A further moderate tightening of sanctions is probable and is factored into the sovereign’s ratings. More punitive measures that would escalate default risk remain a possibility but are not deemed likely, particularly in the short term.